August 04, 2009

Beware of 'Confirmation Bias'

"In the case of any person whose judgment is really deserving of confidence, how has it become so? .... Because he has felt, that the only way in which a human being can make some approach to knowing the whole of a subject, is by hearing what can be said about it by persons of every variety of opinion, and studying all the modes in which it can be looked at by every character of mind. No wise man ever acquired wisdom in any mode but this...." ~ John Stuart Mill

Do you seek out information that agrees with your perspective? Of course you do! And investors are certainly no exception to this behavior. Not only do you prefer to seek views that align with yours but you tend to ignore those that do not. Is this healthy behavior? Perhaps it is and perhaps it is not; however, your humble author will suggest that an awareness of this human tendency is healthy and the unawareness of it is not...

"Faced with the choice between changing one's mind and proving there is no need to do so, almost everyone gets busy on the proof." ~ John Kenneth Galbraith

Confirmation bias is the technical name for people's desire to find information that agrees with their existing view. Information
that reinforces favored preconceptions is over-weighted (also known as
self-attribution bias) and any information that conflicts with this
view is ignored. Taken from an investing perspective, possibly you have said something like this: "Nah, it's a short-term blip -- the market will soon return to its most recent pattern."

"There is no conversation more boring than the one where everybody agrees." ~ Michel de Montaigne

Now that you may be at least a bit more aware of your tendency to over-weight information you find agreeable and to under-weight information that you do not, how may confirmation bias be overcome?

You can begin by attempting to give equal time to information sources with which you agree as to those with which you disagree. No mind has ever grown without stretching beyond its comfort zone. Is it not the blunt stone that sharpens the blade?

Also beware of the mainstream media because it tends to attach itself to the bias of the herd. Have you noticed a recent shift in the media's overall sentiment from bearish to bullish? The popular view seems to be shifting toward stating The Recession is Over. This is the same media that said, less than one year ago, that the US Economy was headed for The Next Great Depression.

When you find yourself overwhelmed with reasons to make a decision to do something, force yourself to come up with reasons why you should not do it (or remember the third alternative -- deferring the decision to a later time).

Simply be aware of what information you consume. If information were food, would your "diet" be healthy? Is it balanced?

Don't be mentally lazy. Complacency is a breeding ground for other potentially damaging behaviors, such as greed and hubris.

"The difference between what the most and the least learned people know is inexpressibly trivial in relation to that which is unknown." ~ Albert Einstein

Any person with a few minutes of time and minimal education level can find data points to support any given view, especially about something that is, at present time, unknown. No matter how convincing an argument (or how strong your attraction to like-minded perspectives) be sure that your decisions are actually yours.

"There is only one side to the stock market; and it is not the bull side or the bear side, but the right side." ~ Jesse Livermore (hat tip to The Kirk Report)

Comments

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This is a very timely post as the debate between the recession is over and a bear market rally rage. However, this post applies to every aspect of our lives. Try convincing a Republican that Obama is doing a good job or a Democrat that Obama is failing. It is a monumental task becasue we cling to our beliefs and embrace only those who support our views.

Truly successful individuals can weight the merits of any position and develop their viewpoint based on a thorough analysis.

The key to learning about behavioral finance is it allows us to understand our natural behaviors and try to improve upon them. As an investor, your best bet is to have an investing philosophy or system and stick to it. Just keep the emotions in check and you will succeed long term. Of course, this assumes your system is based on logic and not emotions like day trading.

You are absolutely correct! Political and moral issues, such as abortion, are arguments that are lost before they begin. Neither side of the argument can be convinced to change their respective position.

I have also learned to open my mind to opposing views as a result of behavioral studies extending from my financial work.

I know this is something that I have to watch out for when looking at macro or big-picture viewpoints - try not to get too bogged down in bearishness on X or a bullish viewpoint on Y.

It's great to have a strong view and make up your own mind on a given issue, but it's also easy to get slowly drawn into a persistent theme ("we're bearish on stocks" or "the economy's fine, stupid!") and parrot the outlook of others, especially when they are the views of people you respect.

This is why I often like to engage people in all types of discussions. Whether you're talking about economics, the environment, or the fate of the country, it's good to hear other other points of view and learn what other people have to say. Even if you believe strongly in your position, you might find that your argument needs a little work :)

Three investment topics immediately come to mind relating to this: (1) the death of the EMH, (2) the dissing of asset allocation as an effective investment strategy, and (3) the resistance to passive management.

I've also found that if I read wide enough and deep enough, I'll find equally compelling positions on both sides of a question. Yet, as an investor, I need to choose my own position.

So I adopt a point of view but always ask, "What happens if I'm wrong?" That helps to keep me grounded.

Great points! Many strategists and theorists are what I call "displayers of knowledge" -- their primary motivation is to appear knowledgeable and their secondary motivation is to appear "right" -- neither or which are difficult undertakings.

I wonder what their marriage is like? Have you heard the saying, "Do you want to be 'right' or do you want to be happy?"

Humility is among the highest and most valuable of virtues and their is a point at which knowledge must give way to judgment.

I often tell my 8-year old son, who loves to prove himself 'right' and his 4-year old brother 'wrong,' that their can be no winner to an argument -- Even if you are right the one you have proved wrong no longer likes you...

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